Arcángel de Jesús Montoya
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Arcángel de Jesús Montoya in Money Trafficking,

Using Current Implied Volatility For Decision-Making

Options are math. The best part about them that the many variables they are comprised of are sort of "fixed". To be specific, there is no guessing about the duration of the options (we all know how to count days), the current market price of the underlying (we all can read numbers), and the risk-free rate (this one may be convoluted at times depending on the duration of the options). The same goes for the dividend yield. The only input that can be considered "variable" is the options' implied volatility - that is, the annualized expected standard deviation of the underlying asset's returns (typically, an expected volatility in a stock's returns). Implied volatility is used by market makers to price options, which are then sold to the options' buyers. Of course, as a buyer, you have to simply accept the assumption, if you really want to buy the options. On the other hand, this is what you "charge for" as a seller - this is the "fat" on top of the options' moneyness. In other words, implied volatility is something that has to be estimated in order to reasonably price the option. In this regard, this is the only "grey" are in options pricing. Hence, you can see that options are priced pretty accurately, as opposed to stocks. The precision is not as accurate as in the case of bonds, which are pure math, but is good enough to consider them as a viable financial instrument for various purposes.  

One of the most fascinating features of implied volatility is that it is mean-reversible. This means that it cannot stay too high or too low for long periods of time. Remember that stock options are essentially side bets around equities. It is reasonable that, when the cost of a bet is unusually low, market participants will load up on it, driving the price of the bet to a more normal level. The same is true for overly expensive options. In addition, experienced traders tend to either hedge their exposure when playing around implied volatility by initiating vertical spreads (e.g. selling an ATM call and buying an OTM call to hedge the upside risk) or buying the underlying or partially finance their positions by selling options with farther exercise prices than the ones they acquired. The whole idea around these implied volatility plays is to capitalize on its mean-reversibility property, while staying away from directional swings, which can definitely offset any profits made from the correct estimation of the true implied volatility range.   

One of the ways to take the right direction in this implied volatility game is to know where the current IV of various options stands. This can be done via a free service called Optionstrategist.com. This service helps identify how short-term options on various stocks are currently priced by telling users where their current implied volatility stands relative to a few hundred daily readings. The data is presented in percentiles. A percentile shows "how much" data in the sample have values below the number of the percentile (e.g. a 95% percentile shows that 95% of historical data have been below the current value of X). In this case, it shows where the options' implied volatility stands relative to its "golden mean". We then assume that, if the options have high IV percentiles, they will go down in value, while the ones with low IV percentiles will likely gain in value in order to reverse to their mean IV values. We can also say that this service shows which options are priced more or less correctly, which options are clearly overprices, and which ones may be considered as buying opportunities. We obviously want to follow the old adage, "Buy low and sell high", and the reverse.

Now that I have provided a link to the service, you can explore it yourselves. I just want to outline three overpriced and three undervalued options that I think are interesting:

Overpriced:

(Source: optionstrategist.com)

The above stocks share a few commonalities:

- None of them is a penny stock. This is important because penny stocks and cheap stock in general are not typically liquid;

- Their one-month straddles are worth at least 10% of the current market price of the shares (at least a 35% annual expected volatility);

- Their current implied volatilities of their short-term options are at the highest over the observed period (99th percentile);

- The options are liquid (i.e. at-the-money options are traded on some volumes).

I particularly recommend the covered call strategy (or selling call spreads) for the above stocks as all of them have recently shown strong positive dynamics. 

Undervalued:

The above stocks share a few commonalities:

- None of them is a penny stock. This is important because penny stocks and cheap stock in general are not typically liquid;

- Their one-month straddles are worth no more than 10% of the current market price of the shares (less than a 30% annual expected volatility);

- Their current implied volatilities of their short-term options are at the lowest over the observed period (1st percentile);

- The options are liquid (i.e. at-the-money options are traded on some volumes).

All stocks on the list (except BBRY) have shown positive dynamics over the last three months. I recommend buying call spreads on these options (or straddles, if you are cautious about the downside exposure). 

I suggest that you look at these options closely and/or explore more companies on the list (simply use the Ctrl + F function to search the percentiles you need).